Does It Pay to Save?

Studies | Taxes

No. 298
Friday, June 01, 2007
by Laurence J. Kotlikoff and David S. Rapson

Measuring Effective Marginal Taxes on Saving

"Saving an additional dollar can cost a family thousands of dollars in benefits.”

While effective marginal tax rates on labor income have been researched extensively, there has been little research on saving. An effective marginal tax rate on labor is the sum of taxes paid plus the reduction in government benefits that occurs when a dollar of income is earned.  For example, many low-wage workers who pay no income taxes lose $1 in benefits when they earn $1.  Thus, their effective marginal tax rate is 100 percent.  For this reason, individuals on temporary assistance may have very little incentive to work.  An additional dollar of saving works the same way through the asset tests required for some transfer programs. 

Determining effective marginal net tax rates on saving requires taking into account effective marginal taxes plus all future transfer payments people might lose from saving.  First, the calculations must include a host of federal personal income taxes, corporate income taxes, payroll taxes, and state taxes, as well as Social Security benefits and welfare benefits - including Temporary Assistance to Needy Families, Supplemental Security Income, Medicaid, food stamps and energy assistance.  Second, how each of these taxes and transfers is calculated must be determined.  Third, the interactions of the different tax and transfer programs must be analyzed.  Finally, how taxes are paid and transfers received over time must be considered. 

This study uses ESPlanner , a personal financial planning software program developed and marketed to the public by Economic Security Planning, Inc., to analyze the marginal tax levied on savers with different expected lifetime earnings.  This software program determines a household's highest sustainable living standard and the saving and insurance needed to sustain it.  In the process, the program makes highly detailed, year-by-year federal and state income tax and Social Security benefit calculations. 

The gain (or loss) from extra saving can be measured by calculating how much current consumption a household must forgo in order to have the same amount of income (adjusted for inflation) available to consume at a later point in time.  Consider, for example, an individual currently age 30 and the same individual at age 65.  If there were no effective marginal taxes on saving, a 30-year-old reducing current consumption by $100 in order to save for retirement would be able to increase consumption by $100 (measured in present value) at age 65.  If, however, at age 65, this individual has only an additional $50 to consume, there is a 50 percent effective marginal tax on saving.

“Effective marginal tax rates include taxes and lost government benefits.”

The simulations of households used in this study examine individuals who live for many years.  When there is more than one period in which to consume - for example, spending saved income over 20 years of retirement - there is no standard definition of the effective tax on saving in the economics literature.  Assumptions about the choices households make affect the results of the simulations.  For example, how much a family that saves $100 today will have to consume in the future depends on when and over what number of years the savings will be consumed.  Different choices will generate different effective tax rates.  This is because the interest earned by savings compounds over time, and (as discussed below) accumulating more than a minimum amount of saving can put a family over the asset limit for certain benefits.  Thus, the longer the period over which a household allocates its saving, or the further into the future the consumption of that saving commences, the higher the effective tax rate will be.

Consistent with economic theory as well as actual behavior, the simulations used in this study assume that, other things equal, people will try to maintain their standard of living - or smooth their consumption - over their lifetimes, even though their wage income fluctuates.  For example, a couple starting out with a modest income may borrow to buy a house or to pay education expenses for their children.  At middle age, when their children have left the nest and their wages are higher, the couple may accumulate savings and pay down their mortgage.  During their retirement years, they live on the savings accrued during their working years.  [See the Appendix for more information on household characteristics.]

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